ISU Economists Find that Replacing Iowa’s Sales Tax Could Save More than $100 Million Per Year

Ames, Iowa -- Replacing Iowa's sales tax with an equivalent income-based tax would increase tax revenue for the state without increasing the overall tax burden on Iowans, says a team of Iowa State University economists.

Budget problems currently facing Iowa and other states may be related not only to the economic slowdown, but may also reflect deeper structural problems requiring a reassessment of both spending and revenue options, the economists say. In particular, state governments should pay more attention to their choice of tax revenues.

The economists who prepared the tax policy analysis are Harvey Lapan, university professor of economics; GianCarlo Moschini, Pioneer chair in science and technology policy; and economics student Brad Caruth.

Their paper, "Are All Taxes Equally Bad? How Replacing Iowa's Sales Tax Could Save Iowans More Than $100 Million per Year," was published this month by Iowa State's Center for Agricultural and Rural Development.

"The basic reason to consider the tax change analyzed in this paper has to do with the federal deductibility of the state income taxes," Lapan said.

Federal law allows up to 100 percent of a taxpayer's state income and property taxes to be deducted from their adjusted taxable income. As a result, Iowans pay about $251 million less to the federal government than they would otherwise pay. There is no equivalent deduction for state sales taxes.

"By eliminating the sales tax and replacing lost revenue with an income-based tax, Iowans could save a substantial amount of money on their federal tax returns without any change in revenue for state coffers," Moschini said. "Alternatively, the state could increase its tax revenue without increasing the total tax burden on Iowans."

There are other advantages to considering the change. Eliminating sales taxes may have some positive impact on local retailing. The reduction in retail prices would make locally sold goods more attractive to Iowans and out-of -state residents. In addition, the rise of Internet commerce makes the sales tax increasingly less effective for state tax collection.

Local options to raise tax revenue could also be easily implemented within an income-based equivalent tax. A similar option already exists in the current Iowa income tax: the school district surtax is calculated as a percentage of the taxpayer's Iowa income tax liability.

The authors present conceptual scenarios which provide benchmark estimates of the net benefits that would flow to the state from replacing the current sales tax with a lump-sum income tax. In one scenario, the estimate is $106.3 million per year; in the other it is $133.9 million per year.

They also present two alternatives for implementing the tax policy change. Both would require only one additional line in the Iowa 1040 form--a "sales tax replacement" line with the amount of the additional tax proportional to taxable income.

For each approach, the authors report two sets of estimates: one where the state's tax revenue remains the same before and after the tax policy change (revenue-neutral), and one where the average tax burden of the taxpayer remains the same (taxpayer neutral). In the first case, the taxpayers get all the benefits; in the second, the state captures all the benefits.

If the state were to adopt the taxpayer-neutral flat tax, which is equivalent to the existing sales tax, the economists estimated that the state would increase its revenue by $157 million per year, without increasing the overall tax burden on Iowans.

"This translates to annual salaries for more than 5,600 new teachers or about one-and-a-half times the state's current spending on substance abuse programs." Moschini said.

The magnitudes of the benefits presented in the paper are estimates, Moschini said. "Alternative experiments with different computational procedures, carried out by Brad Caruth, showed that the estimated gains do not change significantly. Overall, our assumptions and procedure actually provide somewhat conservative estimates," he said.

"The federal government assumes the only major loss under the proposed policy change," Lapan said. "Replacing the state sales tax with an income-based tax would seem to be unquestionably a positive change for Iowans."